Buttonwood
Bankers scratch their heads—and worryJun 7th 2005
From The Economist Global Agenda
SourceAn inverted yield curve may be approaching in America. Do we care? Banks doIT’S official: Alan Greenspan, chairman of the Federal Reserve, is still puzzled by the stubborn refusal of American bond yields to rise in sympathy with the Fed’s upward yanks on short-term interest rates. In his satellite appearance at a monetary conference in Beijing on Monday June 6th, Mr Greenspan entertained the idea that falling long-term yields could signal slowing economic growth, but didn’t wholly buy it. He dismissed other favourite theories as to why yields have failed to follow suit—the fact that foreign central banks and pension funds need to buy Treasuries, the greater incorporation into the world trading system of low-cost producers such as China, thus reducing inflation expectations—as having only a minor influence. The internationalisation of the world’s capital markets, with investors more willing to invest outside their borders, was as likely an explanation as not, he reckoned, rather vaguely.
Whatever the explanation, it suddenly feels like a new scene out there. For months the Fed has pushed the view that economic growth was solid and inflation something to keep an eye on, while the bond market seemed to be answering that inflation was dead and growth prospects dim. Last week the market staged a coup: the yield on the ten-year Treasury fell below 4%. The bonds have continued to trade there ever since and the ranks of those who believe that yields are headed down, not up, are swelling.
Yet the indications are that the Fed will continue to raise short-term rates once or even twice. Inflationary pressures have not gone away: for all the disappointing numbers of new jobs created, the oil price is popping up again and there are concerns about wages. The fed-funds futures contracts traded on the Chicago Board of Trade take for granted that the Fed will raise overnight rates twice more, and that overnight money will be 3.6% by November. The gap between two-year and ten-year Treasuries is now measured in mere tens of basis points, and the dreaded phrase “inverted yield curve” is openly bruited.
Inverted yield curves—when it is cheaper to borrow money for long periods than it is for short ones—have almost always presaged economic downturns. Normally a long-term loan attracts a higher interest rate because the money is tied up for longer and thus subject to more risks. If a lender is willing to accept a lower return on a long-term loan than he could get on a short-term one, it usually means he is worried that economic growth will stall. And he is usually right: every economic decline since the mid-1960s was preceded (within six quarters) by an inverted yield curve, and there was only one “false positive”—ie, economic decline did not follow.
Past performance may be no guide now, Mr Greenspan points out. What does seem clear, however, is that the flattening yield curve has already begun to punish banks and an inverted one would be likely to pummel them. And banks matter, not least because their ability to transform savings into lending fuels economic activity, even in these increasingly securitised days.
Banks respond to the level and slope of interest rates in different ways. Exactly how depends on where they get their funds (eg, virtually free from naïve retail depositors or more expensively from the wholesale markets) and their mix of business (whether they are mainly retail or commercial banks, or investment banks).
Broadly, though, all banks earn money through some combination of maturity transformation (borrowing short and lending long), taking credit risk (ie, lending to people who may not pay it back) and earning fees and punting on their own account in the capital markets. Interest rates affect all of those. In both Europe and America, banks have seen their margins squeezed as the yield curve has flattened, thanks to rising short-term rates. The “carry trade” (borrowing short and cheaply to buy an asset offering a higher yield), which big investment banks engaged in along with their hedge-fund clients, has suffered already—and will suffer more. J.P. Morgan Chase, for one, has warned that its second-quarter results will show that it took an almighty knock in the markets.
“This yield-curve environment is like a new frontier for a lot of these bankers,” says David Hendler of CreditSights, a New York research firm. CreditSights reckons that it has created a headwind for American banks that is equivalent to some 15-25% of estimated earnings per share. To keep revenues afloat regardless, banks are beating the bushes these days for borrowers. And as they do so, they are relaxing their lending terms and conditions, central-bank surveys show. German and Italian banks report persistent pockets of credit-quality weakness and banks in America are watching the hot property market for signs of the same.
Small wonder that when yield curves flatten, fewer ratings changes for financial firms tend to be upgrades, as the chart shows (though the two came unglued in the tumult after the bubble burst in 2000). But Matthew Pugsley of BCA Research in Montreal points out that banks can thrive when the yield curve is reasonably flat: they outperformed the broader market in America between 1995 and 1998, for example, helped by fast-growing loan volumes, good credit quality and booming financial markets. They seem to be running out of puff now, however, as bank earnings expectations are slashed even faster than predictions for the market as a whole.
Andrew Smithers, a London-based economic consultant, gives some of the reasons for this. Bad loans are headed up (they have been so low that they could scarcely head down). The profits from maturity transformation will taper off as banks realise profits on the higher-yielding assets they have now in their portfolios. Non-interest income is dropping faster than non-interest expenses, so the fee-generating leg of banking looks a dubious source of outsized profits in future. And all that is without assuming an inverted yield curve.
Are we going to get one? Probably not, in part because the Fed will have the yield curve well in mind in deciding on future short-term rate hikes and it is all too aware of its impotence to affect long-term yields. Nor need the fate of banks be quite the Götterdämmerung that some suggest. As Simon Maughan of Dresdner Kleinwort Wasserstein points out, with all the innovation in financial markets, “banks have been good at consistently reinventing themselves”. For better or for worse.
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